Housing bubble’s defining delusion: real estate only goes up

What is a Bubble?

A financial bubble is a temporary situation where asset prices become elevated beyond any realistic fundamental valuations because the general public believes current pricing is justified by probable future price increases. If this belief is widespread enough to cause significant numbers of people to purchase the asset at inflated prices, then prices will continue to rise. This will convince even more people that prices will continue to rise. This facilitates even more buying. Once initiated, this reaction is self-sustaining, and the phenomenon is entirely psychological. When the pool of buyers is exhausted and the volume of buying declines, prices stop rising; the belief in future price increases diminishes. When the remaining potential buyers no longer believe in future price increases, the primary motivating factor to purchase is eliminated; prices fall. The temporary rise and fall of asset prices is the defining characteristic of a bubble.

The bubble mentality is summed up in three typical beliefs:

The expectation of future price increases.

The belief that prices cannot fall.

The worry that failure to buy now will result in permanent inability to obtain the asset.

The Great Housing Bubble was characterized by the acceptance of these beliefs by the general public, and the exploitation of these beliefs by the entire real estate industrial complex, particularly the sales mechanism of the National Association of Realtors.

Speculative bubbles are caused by precipitating factors. Like a spark igniting a flame, a precipitating factor serves as a catalyst to begin the initial price increases that change the psychology of market participants and activates the beliefs listed above. There is usually no single factor but rather a combination of factors that stimulates prices to begin a speculative mania. The Great Housing Bubble was precipitated by innovation in structured finance and the expansion of the secondary mortgage market, the lowering of lending standards and the growth of subprime lending, and to a lesser degree the lowering of the Federal Funds Rate. …

The first section was on what I considered the primary false belief that inflated the bubble:

Real Estate Only Goes Up

The mantra of the National Association of Realtors is “real estate only goes up.” This economic fallacy fosters the belief in future price increases and the limited risk of buying real estate. In general real estate prices do increase because salaries across the country do tend to increase with the general level of inflation, and it is through wages that people make payments for real estate assets. When the economy is strong and unemployment is low, prices for residential real estate tend to rise. Therefore, the fundamental valuation of real estate does go up most of the time. However, prices can, and often do, rise faster than the fundamental valuation of real estate, and it is in these instances when there is a price bubble.

Greed is a powerful motivating factor for the purchase of assets. It is a natural response for people to desire to make money by doing nothing more than owning an asset. The only counterbalance to greed is fear. However, if a potential buyer believes the asset cannot decline in value, or if it does, it will only be by a small amount for a very short period of time, there is little fear generated to temper their greed. The belief that real estate only goes up has the effect of activating greed and diminishing fear. It is the perfect mantra for creating a price bubble.

I went on to list other false beliefs such as:

Buy Now or Be Priced Out Forever

They Aren’t Making Any More Land

Everyone Wants To Live Here

Prices Are Supported By Fundamentals

It Is Different This Time

But those are what I termed confirming fallacies because they all support the central premise that real estate prices can only go up.

I am not the only housing analyst who came to this conclusion. A Federal Reserve economist, Paul Willen, has been labeled a renegade for loudly expounding the same belief.

In the years since the start of the biggest American financial crisis in generations, the reasons for the meltdown have begun to harden into conventional wisdom. Everyone agrees on the root of the problem: a housing market that ballooned wildly, then collapsed. But exactly where to place the blame is a matter of dispute. Conservatives tend to point the finger at the individual homeowners who took out loans they were incapable of paying back—and ultimately, at the government that pushed for looser lending standards in the first place. Those who lean left point squarely at the financial industry, which flooded the market with deceptive mortgages and then sold the risk off in the form of complicated new securities.

Both sides are half right, and neither side understands the cause.

Then there’s Paul Willen, a research economist at the Federal Reserve Bank of Boston.

Willen, a 44-year-old father of two who lives in Brookline, moves through the world in a state of dismay and occasional fury at the fact that absolutely no one—not the media, not the public, and not his fellow economists—seems to understand the truth about what happened. Since 2008, Willen, a mortgage specialist, has pored over troves of data and emerged with a powerful, counterintuitive conclusion: that the real reason everything ended so badly wasn’t adjustable rate loans, or government housing policy, or esoteric financial instruments. Rather, it was a single underlying assumption that almost everyone in the market, from bankers to home buyers, shared: that American house prices would continue to go up indefinitely.

Willen has spent the past four years trying to persuade people of what he sees in the data: that everyone in the drama acted perfectly rationally. Under the assumption that the real estate market would continue its steady rise, it made sense for families to buy homes they couldn’t afford, and it made sense for bankers to buy up subprime mortgages. This belief —Willen thinks of it as a mass delusion—fueled an immense bubble that could not be reliably identified for what it was.

This delusion didn’t make sense, but it is true that people were acting rationally based on the foolish fallacies they eagerly embraced.

If he’s right, then the finger-pointing that’s occurred since the crash—the belief that the various actors should have understood that housing was overvalued, that credit was being extended too freely, that somehow the Fed could have cooled it down—is beside the point. Rather, Willen argues, we should humbly come to terms with the frightening fact that when economic delusions take hold, none of us may be able to tell that we’re being swept up in them.

That’s just wrong. Being caught up in a mass insanity does not relieve any of the players of responsibility for their actions. It may explain it, but it does not justify it. Many of man’s greatest atrocities were committed by people just following orders or doing what the group was doing. Rioters are not excused just because everyone else was doing it.

Since 2008, Willen has been pressing his theory about the crisis in a series of academic papers and lectures. But while his job at the Fed gives him access to policy makers in the central bank, he has found himself firmly in the role of outsider in his own field. Critics say he underplays the extent to which the crisis was made more grave because of reckless decisions by lenders and bankers, and some suggest it’s a cop-out—a way to spin the problem so that no one, especially the Fed, has to take any blame for what went wrong.

Yes, that is exactly how his statements can be interpreted. If that is his intent, shame on him.

A number of the economists Willen has singled out for criticism declined to weigh in for this article. But one of them, Stijn Van Nieuwerburgh, who heads the Center for Real Estate Finance Research at NYU’s Stern School of Business, said in an interview that he thinks Willen is essentially dodging the question of the bubble’s causes.

“The assumption is that this happened for some random reason,” he says, “unrelated to regulation, unrelated to supervision, unrelated to anything….Economists like to call this a sunspot—something that came out of nowhere.”

That particular dodge is particularly infuriating. Nobody at the federal reserve wants to place any blame on their member banks, and the bulk of the responsibility falls on lenders.

In Van Nieuwerburgh’s view, the bubble does have a cause. “The Federal Reserve Bank, as well as Congress, were gradually, slowly but surely, relaxing their oversight of the financial sector,” he said. “And just to give you one number: There were something like 700 laws passed in Congress over this period, all of which made it easier for people to access their home equity, made the regulations on banks less, made the regulations on mortgage borrowers less, and so forth. And this obviously is the story that the Fed, including people like Paul Willen, who work for the Fed, don’t want to tell.” …

Yes. Nobody at the fed wants to take any responsibility. Doesn’t their excuse sound like the dog eating their term paper?

This point of view puts him on the pessimistic side of a longstanding debate. One side says it’s possible for policy makers to identify bubbles while they’re happening and try to “prick” them so they don’t cause big problems. The other says economics simply can’t detect a bubble until after it has burst, and that all we can hope for is a quick recovery afterwards.

It’s true that economists as a group are very poor at identifying bubbles. As a group, most economists have no idea what they are talking about. Few if any understand the linkage between the incentives of individuals and the macro impact the herd of individuals create.

The debate cuts to the heart of what economics can tell us about value. To say a bubble exists is to argue that the price of something, like a house, has wildly exceeded its true value. But a basic tenet of economics is that the value of an asset is whatever people will pay for it: It’s impossible to say an iPhone isn’t “worth” $300 until the day comes when nobody will buy it for that much.

But even if the intrinsic or fundamental value of something is unknowable, some economists still believe that it’s possible to determine when the price of an asset has come untethered from reality—that is, to detect a bubble while it’s forming.

One reason I like the rental parity indicator is because it does accurately identify bubbles as they are forming. It takes into account changes in what people are willing to spend on housing, the impact of mortgage rates, and other variables most economists guess at. The last two bubbles are easily identifiable when you compare prices to rental parity. The current overshoot to the downside is also apparent. It will be interesting to see how rental parity fares as an indicator when mortgage rates go up and the other market manipulations end. We may see the first significant decline in rental parity.

If we could do that, then the Fed and the markets actually would be able to make smarter decisions that prevent bubbles. Even Willen is hopeful on that front. “If it was really clear when there was a bubble,” Willen said, “the bubbles would never happen in the first place….So at some point, one could imagine that the economy as a whole, partly through our better understanding of these things, would just become a less volatile place.”

I have my doubts federal reserve economists will agree on the right course of action even if they can agree on a bubble. Some economists will vehemently disagree with their colleagues. Many economists get caught up in their own confirmation biases and interpret incoming data through the filter of what they want to see happen (anyone noticed this in Calculated Risk since he called the bottom?) Reaching a consensus will be difficult. Just look at the problems the Canadians, Chinese, and Australians have admitting to their housing bubbles.

Willen warns that this vision is more fantasy than practical plan. For now, he argues, we need to start acknowledging the limits of what economics can tell us, and come to terms with the fact that next time there’s a bubble, we probably won’t know about it until it’s too late. Until we accept this deeply unsatisfying reality, according to Willen, we risk deluding ourselves into believing we are no longer vulnerable to the problems that led to the 2008 crisis.

“Going forward, what worries me is that sometime in my lifetime, not that far in the future, we will have another house price boom, and people will say, ‘We have nothing to worry about…because we’ve regulated away all the bad things that people did.’ That will be wrong.”

I hope no one believes we have made any progress toward regulating away the roots of the 2008 financial crisis. We have done nothing. We haven’t even dismantled the too-big-to-fail institutions responsible for massive government bailouts. We are encouraging mortgage equity withdrawal as economists hope the “wealth effect” of rising house prices will save the economy. Nothing in the Dodd-Frank law will prevent a future disaster, and we failed to bring back good regulation like Glass-Steagall that might have made a difference. The lobbyists for the financial services industry still own Congress and their regulators. No. We have done nothing to prevent the next disaster. I’m not sure anyone thinks we have.

The banks are trying to hit their quotas for the settlement. Short sales count toward the settlement amount whereas foreclosures don’t.

For a long time everyone was touting short sales as better than foreclosures because the capital recovery is better. In a declining market that is true because short sales spend so much time in escrow that the market drops while the banks consider approval. In a rising market, the opposite is true. Banks will recover less in a short sale when prices go up because they are locked in to a lower price when the deal was made.

(Reuters) – When Federal Reserve policymakers meet next month to decide whether to take action to boost the economy, it will be a “close call,” a top Fed official said on Thursday on the eve of a speech by Chairman Ben Bernanke that has global markets on tenterhooks.

Atlanta Fed President Dennis Lockhart, a centrist voter on U.S. monetary policy, said further stimulus would have some positive effect on the U.S. economic recovery, but cautioned that the costs of such action are not altogether clear.

“If we were to see deterioration from this point – let’s say persistence of job growth numbers that were well below 100,000 a month … or if we were to see signs of disinflation that could signal the onset of deflation – then there wouldn’t be much of a question about policy,” Lockhart told CNBC.

“But now I think the policy question is, how much will you gain and of course what are the costs in the short and longer term,” he said as an annual central bankers symposium kicked off in Jackson Hole, Wyoming.

Financial markets are abuzz with speculation that Bernanke could hint at a third round of asset purchases known as quantitative easing, or QE3, when he takes the podium on Friday – and that Fed policymakers could adopt the plan at their September 12-13 meeting.

The Fed in late 2008 slashed interest rates to near zero and has bought $2.3 trillion in assets in an unprecedented drive to revive the economy after the worst recession in decades. Yet the recovery, especially in jobs, has been slow and economic growth stumbled this year, stoking expectations the Fed will act again.

But with economic data in recent weeks relatively better, and some central bankers worried that QE3 would have little benefit, nothing is certain.

One of the Fed’s most prominent policy hawks, Charles Plosser of the Philadelphia Federal Reserve, warned that there is no point in launching another asset-buying program, in part because it risks future inflation.

“My current assessment both of the economy and the effectiveness of QE is that I don’t think it really beats the cost-benefit test right now,” Plosser said on CNBC.

Although Plosser said it is possible that QE3 could bring down interest rates somewhat, he warned that the massive cash reserves now on bank balance sheets could eventually drive up prices and hurt the economy.

“When those excess reserves … begin to flow out into the economy, that’s when the risk of inflation will become even more heightened than it is now,” he said. “Right now it’s just a risk.”

Right now, most people are financing the max at super-low rates. The only way prices go up is if wages go up and interest rates remain low. It seems more likely that interest rates would go up while wages stagnate.

Frank Nothaft, VP and chief economist for the GSE, said the declines economic news that may indicate another stimulus is on the way.

“Treasury bond yields fell, allowing mortgage rates to follow, after the release of the July 31 and August 1 minutes of the Federal Reserve’s monetary policy committee,” Nothaft said. “Committee members agreed that economic activity had decelerated more in recent months than they had anticipated at their last meeting in June. Some members even saw room for additional stimulus fairly soon if need.”

Despite the overall waning of the economy, Nothaft was quick to note that the housing market has gained more ground.

“Nonetheless, the housing market continued to show improvement over the past few months,” he said. “New home sales rose 3.6 percent in July, matching May’s pace as the strongest month since April 2010. Similarly, pending home sales also rose in July to its highest rate since April 2010.”

Bankrate’s survey showed that the 30-year fixed average took a substantial tumble, falling to 3.80 percent from 3.91 percent before. The 15-year fixed also saw a fairly large drop, averaging 3.03 percent (from 3.12 percent the previous survey).

Company analysts and financial experts surveyed by Bankrate mostly believe mortgage rates will either remain stable or trend down in the near future.

“The minutes of the Federal Reserve’s most recent meeting gave investors hope that additional Fed stimulus might be close at hand. All eyes now turn to Jackson Hole, Wyoming for Fed chairman Ben Bernanke’s speech on August 31. If he even hints at forthcoming stimulus, both Treasury yields and mortgage rates will tumble further. Mortgage rates are closely related to yields on long-term government bonds,” Bankrate said in a release.

However, not all analysts agree. Senior mortgage reporter Polyana de Costa said she sees evidence of an upward trend to come.

“The latest economic reports have been somewhat positive, which might put some upward pressure on rates next week. If [Fed chairman Ben Bernanke] disappoints investors Friday – and I think he will – rates will probably increase slightly,” de Costa said.

Fannie Mae and Freddie Mac are increasing their fees. There is also called mortgage that is collected by Fannie and Freddie and sent to the US Treasury. Will these fees keep increasing close to the level FHA charges.

Fannie Mae and Freddie Mac will raise their guarantee fees charged to lenders by an average 10 basis points in order to encourage more private capital to fund the market, according to the Federal Housing Finance Agency.

“These changes will move Fannie Mae and Freddie Mac pricing closer to the level one might expect to see if mortgage credit risk was borne solely by private capital,” said FHFA Acting Director Edward DeMarco.

For loans sold to the government-sponsored enterprises for cash, the higher fees go into effect Nov. 1. For others exchanged for mortgage bonds, the effective date is Dec. 1.

The FHFA said Friday the new raises will narrow the gap between what Fannie and Freddie charge lenders who deliver large volumes of loans with those who originate fewer.

The GSEs will also increase on mortgages with maturities longer than 15 years more than those home loans with shorter terms. This, the FHFA said, will reduce cross-subsidies between higher-risk and lower-risk mortgages.

Lenders paid an average 28 basis points in 2011 for Fannie and Freddie to guarantee their loans in the bonds issued to investors, up from 26 bps the year before, according to a report released by the FHFA Friday.

The GSEs raised their fees by 10 basis points in April in order to pay for a tax cut passed by Congress in December. But before the enactment, the FHFA pledged to raise the fees through 2012 in order to allow private issuers room to compete.

The FHFA said Friday the new raises will narrow the gap between what Fannie and Freddie charge lenders who deliver large volumes of loans with those who originate fewer.

The GSEs will also increase on mortgages with maturities longer than 15 years more than those home loans with shorter terms. This, the FHFA said, will reduce cross-subsidies between higher-risk and lower-risk mortgages.

Fiscal cliff fears are here. With nearly $500 billion in simultaneous tax hikes and spending cuts set to take effect in January, economists have been forewarning the devastating consequences the so-called “fiscal cliff” could cause if Congress fails to come to a budget agreement before the end of the year. The latest report hails from the Congressional Budget Office (CBO), warning that inaction could plunge the U.S. into a “significant” recession in the first half of 2013.

Economists have focused primarily on the impact to overall gross domestic product (GDP), the financial markets, and businesses’ bottom lines. But what about housing? The fragile sector is just starting to experience a nascent recovery, providing what countless economists have called a “bright spot” in an otherwise weak economy. How could a looming cliff affect the sector that triggered the Great Recession in the first place?

“Most consumers aren’t paying attention to the fiscal cliff. If the [local] housing affordability condition is good and they can get a mortgage, they are in the market,” says Lawrence Yun, chief economist of the National Association of Realtors (NAR). “However if the cliff was to be realized come January 1st and we do go into a recession, job losses could hamper the housing recovery.”

And housing has arguably begun to recover (albeit unevenly, with some markets still suffering losses). On Wednesday, July pending home sales were at their highest level in more than two years, according to NAR, and inventory continues to contract. The association projects home prices will increase 10% cumulatively over the next two years. Tuesday’s S&P Case-Shiller home price index for June showed similarly hopeful signs: the 20-city composite index showed prices up 1.2% in the first year-over-year gain since September 2010. And Fannie Mae economists estimate that residential investment in 2012 will positively contribute to GDP for the first time since 2005.

Yet the CBO projects a fiscal cliff could cost the U.S. two million jobs next year and cause the unemployment rate to stay stubbornly stuck above 8% through 2014. Fewer jobs could translate into less demand for new homes, possibly even a new wave of foreclosure filings as newly unemployed workers struggle to make mortgage payments.

Heavy burdens and lower pay now raise fears of depressed spending and growth into the future

By Danielle Kurtzleben
August 29, 2012 RSS Feed Print

Americans are getting their debt under control…that is, unless you count the pesky little problem of student debt. Since household debt peaked in late 2008, student loan debt has grown by $303 billion to $914 billion, while other types of household debt fell by $1.6 trillion, according to data released today by the New York Federal Reserve Bank.

[Read the latest news about U.S. economic growth.]

Student debt is not a large portion of household debt—as of the second quarter of 2012, student loans made up 8 percent of household debt, compared to the 72 percent contributed by mortgage debt—but it could pose widespread economic problems both now and in the future for a generation that’s already struggling.

“Even if the economy recovers, students graduating now or a couple years previous to this, as well—their earnings potential has been hit by the lackluster employment situation,” says David Nice, associate economist at Mesirow Financial, a Chicago-based financial services firm.

People under 30 account for nearly one third of all student debt in the U.S., and younger workers are having an especially difficult time in the job market, with an unemployment rate of 13.5 percent for workers ages 20 to 24, and 9.3 percent for workers 25 to 29 (only unadjusted numbers are available for 25-to-29-year-olds). When these workers are unemployed now or underemployed, working in retail or waiting tables out of college, it means a lifetime of lower pay, says Nice.

“Each raise is impacted even for those who do find a job, starting off at a lower wage. Then over time, their earnings potential is always tied to that salary,” he says.

Yep. Inflation adjusted prices for real estate will continue to decline for quite a while. Even if the fed can get nominal prices to rise, it will likely be accompanied by inflation that exceeds the rate of appreciation.

[…] defense, they were merely believing the “experts” from the NAr who were telling them house prices only go up, their running out of land, buy now or be priced out forever, and so on. Historical episodes of […]

[…] defense, they were merely believing the “experts” from the NAr who were telling them house prices only go up, their running out of land, buy now or be priced out forever, and so on. Historical episodes of […]